“No it’s fine. I don’t need to keep track of inventory. I’ll just count it at the end of the year for the accountant. For some reason, she needs that number to file my taxes. But that’s all I do with it.”
I’ve heard some version of this statement more than once.
But do you sell a product? If so, do you know how much that product really costs you? If you make that product yourself, you might not know how much it costs.
If you don’t know how much your product costs, you won’t know if you’re making a profit.
If you only count your inventory once each year, you may be able to tell if you were profitable for that year.
But you won’t know how you’re doing throughout the year. So you won’t be able to make adjustments if you need to.
Let’s look at some fictional examples so you can see what I’m talking about.
Katie runs a business where she makes and sells decorative belts. She uses webbing, buckles, buttons, embroidery floss, sequins, sea shells, and other fun baubles.
At the end of the year, she spends a whole day counting what she has on hand and figuring out how much each of those things cost her, sorting through receipts and matching them up with the products.
And let’s be real. She makes up a number or two because who can remember if these blue shells are the blue shells she got from Shelly’s Emporium or the ones she got from Sally’s Seashells, am I right?
And what about the belts she’s already made? How much did each of those cost? She has to figure out how much raw product went into each one and decide how much they cost.
This is exhausting. She makes a mental note to sell out of more stock at Christmas time next year so she has less to count.
Once she’s gotten through this harrowing process, she gives that number to her accountant. Yay. She did her duty for the year.
But she has no idea what it means. Did she make a profit?
Let’s see if Emily does any better.
Emily makes and sells popsicle stick picture frames. She uses popsicle sticks, glue, paint, beads, cardboard, string, and other fun decorations.
She knows that she has to give her inventory number to her accountant at the end of the year. She also knows it’s important to look at her financial statements each month. So she adds up her receipts at the end of the month and calls all of the materials she bought “cost of goods sold.”
At the end of the year, she told her accountant how much she had in inventory.
In January, she bought $375 worth of materials and sold $925 worth of picture frames. “Wow, that’s a $550 profit,” she thinks. “I must be doing great.”
Then in February, she buys $200 worth of materials, but only sells $175 of picture frames. “Oh, no,” she thinks. “I lost money this month.”
This goes on throughout the year until she adds up the end of year inventory (which isn’t difficult, because she’s been keeping track of how much each item cost her throughout the year). She tells her accountant how much inventory she has left this year. Done and done!
So she counted her inventory, but did she use that number to determine her profit? Not really.
Let’s look at Cyndi to find out what Katie and Emily were missing.
Cyndi makes macrame plant hangers. She uses different types of yarn and twine, plus lots of different types of beads.
Cyndi knows that she has to give her inventory number to her accountant, and she adds up her receipts each month.
But she also knows that when she purchases the materials, they aren’t “cost of goods sold,” because she hasn’t sold them yet. Cyndi puts this total purchase into an inventory asset category in her bookkeeping software. Cyndi knows that purchasing assets doesn’t affect her profit (at least not at the time of purchase).
To make things even easier for Cyndi, she actually has two inventory asset categories in her software. One is for raw materials, and one is for finished products. When she makes something from her raw materials, she moves the amount of money those materials cost her from the raw materials category to the finished products category. This still has no effect on her profit.
Once Cyndi sells one of her macrame plant holders, she moves the amount the inventory cost her from her inventory assets category to her cost of goods category.
If she bought $750 worth of raw materials, then she made 35 macrame plant hangers from $175 worth of that material, she still has $750 worth of inventory total -- $575 in raw materials, $175 in finished products.
When she sells 10 plant hangers for a total of $500, how much gross profit do you think she makes? (Gross profit is the amount of profit before other expenses like rent, utilities, marketing, and wages are subtracted.)
Well, let’s see…
It’s not a $250 loss, as Emily would have thought...Spending $750 and bringing in $500.
By dividing $175 by 35 plant hangers, we can see that each plant hanger cost $5 to make. Since 10 plant hangers were sold, only $50 is considered the cost of those sales (10 plant hangers times $5 each).
So Cyndi made a $450 gross profit on those 10 macrame plant hangers...($500 income minus $50 cost of goods sold).
With Katie’s method of counting she could figure out her profit each year by doing a little math. And Emily could figure out her monthly profit.
They just have to take the amount of inventory they ended with, subtract the amount they started with, and depending on whether that number came up positive or negative, either add or subtract that from the total they spent on materials throughout the year (or month) to get their true cost of goods sold. Then they would subtract that number from the amount of money they brought in. And voila. Gross profit.
Looking at this number annually is great for figuring out your taxes. But looking at it more often can help you figure out if you need to raise your prices or find cheaper raw materials.
I know that looking at all the steps involved in this process can make it seem really tedious to keep track of. And who wants to do all that math?!
But if you set it up in your bookkeeping system correctly, the software does most of the math for you. You just have to enter the info and double check the work.
If you want to learn more about how to set up your specific inventory system, or if you’re ready to have someone do it for you, book a 15 minute call and let’s talk about how to get that going.